Dynex Capital, Inc. — Q2 2014 Form 10-Q
Reporting period: Three and six months ended June 30, 2014. Amounts below are in U.S. dollars; financial statement amounts are converted from thousands to millions unless noted.
Business context
Dynex is an internally managed mortgage REIT that invests on a leveraged basis in Agency and non-Agency mortgage-backed securities (MBS), including residential MBS (RMBS), commercial MBS (CMBS) and CMBS interest-only securities. Its principal income source is the spread between investment income and financing costs. The company targets long-term risk-adjusted returns, with regular dividends and capital preservation as key objectives.
Financial performance and position
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Interest income | $27.7 million | $33.9 million | $55.4 million | $66.9 million |
| Net interest income | $21.1 million | $22.4 million | $41.2 million | $45.0 million |
| GAAP net income (loss) to common shareholders | $(8.3) million | $29.4 million | $(11.3) million | $47.8 million |
| GAAP diluted earnings (loss) per common share | $(0.15) | $0.54 | $(0.21) | $0.88 |
| Core net operating income to common shareholders (non-GAAP) | $14.1 million; $0.26/share | $16.4 million; $0.30/share | $27.9 million; $0.51/share | $33.4 million; $0.61/share |
| Comprehensive income (loss) to common shareholders | $26.9 million | $(67.2) million | $53.4 million | $(39.8) million |
Quarterly GAAP results were driven chiefly by a $23.1 million net derivative loss, compared with an $11.4 million gain in Q2 2013. For the first half, derivative losses were $36.5 million versus gains of $11.3 million in 2013. The filing attributes 2014 derivative losses primarily to declining rates, which reduced the value of hedges. In contrast, gains in the fair value of MBS were recorded mainly in other comprehensive income (OCI); first-half OCI was $64.8 million.
- Margins: Q2 GAAP net interest spread was 2.04%, versus 1.75% a year earlier. Adjusted net interest spread, a non-GAAP measure that incorporates derivative periodic interest costs, was 1.92%, versus 1.72%. First-half adjusted spread was 1.90%, versus 1.85%.
- Cash flow: For the six months, operating activities provided $105.5 million and investing activities provided $47.4 million; financing activities used $185.5 million. Cash and cash equivalents declined $32.5 million to $36.8 million. Operating cash flow should not be read as a proxy for recurring earnings given the portfolio’s trading and noncash valuation adjustments.
- Balance sheet and debt: At June 30, total assets were $4.116 billion, total liabilities $3.503 billion and shareholders’ equity $612.9 million. Repurchase agreements were $3.447 billion, down from $3.581 billion at year-end 2013; their weighted-average rate was 0.54%. Total liabilities were 5.7 times equity, down from 6.2 times at year-end.
- Liquidity: Management reported $201.2 million of available liquid assets: $36.8 million unrestricted cash, $161.2 million unencumbered Agency MBS and $3.2 million unrestricted derivative cash collateral. Restricted cash was a further $30.7 million on the balance sheet.
- Book value and distributions: Common book value per share rose 2.8% during Q2 to $9.12 from $8.87 at March 31. The common dividend declared for Q2 was $0.25 per share, compared with $0.29 in Q2 2013. Preferred dividends were also paid.
Changes versus comparable periods and portfolio
- Q2 net interest income declined 5.8% year over year; first-half net interest income fell 8.5%. Management cited a smaller average investment balance and lower investment yields, partly offset by lower funding costs.
- Core net operating income, the company’s non-GAAP measure, declined year over year both in Q2 and the first half, principally due to lower adjusted net interest income.
- The portfolio continued shifting from RMBS toward CMBS and CMBS IO. At June 30, Agency MBS represented 81.5% and non-Agency MBS 17.2% of investment fair value. CMBS and CMBS IO together were 37.2% of the portfolio, versus 32.7% at year-end 2013.
- Management redeployed principal payments and sales proceeds from lower-yielding Agency ARMs and near-reset hybrid ARMs into higher-yielding CMBS. First-half purchases included $171.3 million of non-Agency MBS, including $132.9 million of non-Agency CMBS IO.
- The company reduced repurchase borrowings and shortened their weighted-average original term to 70 days from 114 days at year-end, citing lower funding costs and improved repo-market liquidity. It maintained a higher-than-normal liquidity level amid tight credit spreads.
Outlook, risks and contingencies
- Outlook: No specific earnings or dividend guidance is provided. Management said it expected CMBS and CMBS IO to continue offering relatively attractive risk-adjusted returns and saw longer-term Agency RMBS opportunities as the Federal Reserve reduced asset purchases. It maintained a positive duration gap, described as little changed from Q1.
- Market and rate risks: Management cited tight credit spreads and the possibility of a sharp reversal, which could reduce investment values and create liquidity demands. Its modeled sensitivity to an immediate parallel rate increase of 100 basis points was a 21.7% decline in adjusted net interest income and a 1.28% decline in market value; a 50-basis-point increase implied declines of 9.7% and 0.59%, respectively. These are model estimates, not forecasts, and exclude spread changes from the rate-shock market-value calculation.
- Funding and leverage: Most repo financing is short-term, uncommitted and renewable at lender discretion; declines in collateral values can prompt margin calls. Counterparty concentration, cross-default provisions and possible regulatory changes to bank capital and wholesale funding could affect financing availability or cost. The company reported compliance with its financing covenants at June 30.
- Other risks: Results are sensitive to interest rates, credit spreads, prepayments, reinvestment opportunities, non-Agency credit performance, derivatives and GSE reform. Management’s duration target was 0.5 to 1.5 years. Approximately 67% of non-Agency CMBS investments consisted of Freddie Mac Multifamily K Certificates, which are not guaranteed by Freddie Mac.
- Legal matters: The company reported various proceedings and said their resolution was not expected to materially affect consolidated financial condition or liquidity, though an individual period’s results or cash flows could be affected. A putative class action was dismissed with prejudice on June 30, 2014; plaintiffs were expected to appeal.
- Controls: Management concluded disclosure controls were effective as of June 30, 2014 and reported no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether the reported book-value increase and MBS fair-value gains are sustainable if credit spreads widen, and how much exposure rests on model-based valuations.
- How derivative fair-value changes affect reported GAAP earnings, and how the non-GAAP core-income and adjusted-spread reconciliations compare with recurring economic performance.
- Whether short-term repo financing remains available on acceptable terms, including the potential effects of margin calls, collateral haircuts, lender concentration and regulatory changes.
- Credit quality, concentration and prepayment performance of non-Agency CMBS and CMBS IO, including the non-guaranteed multifamily exposures.
- Whether dividend levels remain supportable relative to earnings, cash flows, REIT distribution requirements and the company’s liquidity needs.
- The status and potential financial consequences of the appeal in the dismissed class action and other disclosed legal proceedings.